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Amortized economic value added

What Is Economic Value Added (EVA)?

Economic Value Added (EVA) is a financial performance metric that measures a company's true economic profit after accounting for the cost of all capital employed, including both debt and equity. It is a concept within the broader field of corporate finance that emphasizes the creation of shareholder value. Unlike traditional accounting profit measures, EVA considers the opportunity cost of the capital that investors have tied up in the business, asserting that a company only creates wealth if its earnings exceed the minimum return required by its capital providers. A positive Economic Value Added indicates that a company is generating value above its capital costs, while a negative EVA suggests value destruction.72, 73, 74, 75

History and Origin

The concept of Economic Value Added was popularized and trademarked by the management consulting firm Stern Stewart & Co. in the early 1990s69, 70, 71. Joel Stern and G. Bennett Stewart III founded Stern Stewart & Co. in New York in 198267, 68. While the underlying principles of economic profit and residual income had existed for centuries, Stern Stewart refined and aggressively marketed EVA as a comprehensive financial management system64, 65, 66. Joel Stern, the creator and developer of Economic Value Added, aimed to provide a metric that would align management incentives with shareholder wealth creation, addressing the shortcomings of traditional accounting measures that often failed to capture the true economic performance of a firm62, 63. By the mid-1990s, the adoption of EVA gained significant traction among large, well-known businesses in the United States61.

Key Takeaways

  • Economic Value Added (EVA) quantifies a company's true economic profit by subtracting the cost of capital from its after-tax operating profit.59, 60
  • It serves as a powerful indicator of whether a company is creating or destroying shareholder value above and beyond the required return on its invested capital.58
  • EVA encourages managers to make decisions that efficiently utilize invested capital and improve operating margins.57
  • A positive EVA signifies value creation, while a negative EVA points to value destruction.55, 56
  • Its calculation often involves significant adjustments to traditional accounting figures to better reflect economic reality.

Formula and Calculation

The basic formula for Economic Value Added (EVA) is:

EVA=NOPAT−(Invested Capital×WACC)\text{EVA} = \text{NOPAT} - (\text{Invested Capital} \times \text{WACC})

Where:

  • NOPAT (Net Operating Profit After Taxes) is the company's operating profit after taxes, but before financing costs. It represents the total pool of profits available to capital providers.53, 54
  • Invested Capital is the total capital employed in the business, typically calculated as the sum of interest-bearing debt and equity, or net assets minus non-interest-bearing current liabilities.
  • WACC (Weighted Average Cost of Capital) is the average rate of return a company expects to pay to all its capital providers (both debt and equity holders). It reflects the minimum rate of return required to compensate investors for the risk they undertake.51, 52

To calculate EVA, a company first determines its NOPAT. This often involves adjusting traditional accounting figures, such as converting operating leases into financial expenses or capitalizing research and development (R&D) expenditures, to better reflect the underlying economic realities rather than just accrual accounting practices48, 49, 50. Next, the total invested capital is determined, followed by the calculation of the Weighted Average Cost of Capital. Finally, these components are combined to yield the Economic Value Added.

Interpreting the Economic Value Added

Interpreting Economic Value Added involves assessing whether a company is generating returns that adequately cover its cost of capital and create additional value for shareholders. A positive EVA indicates that a company's Net Operating Profit After Taxes (NOPAT) exceeds the capital charge, meaning the business is generating wealth above the minimum required return for its investors. This signals efficient use of capital and effective management.46, 47

Conversely, a negative EVA suggests that the company is not earning enough profit to cover its cost of capital, thereby destroying shareholder value. While a negative EVA in a single period might not be catastrophic—for instance, if a company is making substantial long-term investments—a consistent pattern of negative Economic Value Added usually indicates underlying operational or strategic issues. Ana44, 45lyzing EVA trends over time, and comparing it to industry peers, provides valuable insights into a company's long-term financial performance and capital efficiency.

##42, 43 Hypothetical Example

Consider "Tech Solutions Inc.," a software company with the following simplified financials for the year:

  • Net Operating Profit After Taxes (NOPAT) = $5,000,000
  • Total Invested Capital = $40,000,000
  • Weighted Average Cost of Capital (WACC) = 10%

Using the EVA formula:

EVA=NOPAT−(Invested Capital×WACC)\text{EVA} = \text{NOPAT} - (\text{Invested Capital} \times \text{WACC}) EVA=$5,000,000−($40,000,000×0.10)\text{EVA} = \$5,000,000 - (\$40,000,000 \times 0.10) EVA=$5,000,000−$4,000,000\text{EVA} = \$5,000,000 - \$4,000,000 EVA=$1,000,000\text{EVA} = \$1,000,000

In this scenario, Tech Solutions Inc. has an Economic Value Added of $1,000,000. This positive EVA signifies that the company generated $1,000,000 in economic profit above the cost of the capital invested. It indicates that the company is effectively utilizing its invested capital and creating value for its shareholders. This metric guides the assessment of how well the company's operations are performing relative to its financing costs and helps evaluate the effectiveness of its capital allocation decisions.

Practical Applications

Economic Value Added (EVA) is widely used in various facets of financial analysis and corporate management, particularly in corporate finance and strategic planning.

  • Performance Measurement and Management: Companies use EVA to assess the financial performance of the entire organization, its divisions, or even individual projects. It helps identify which parts of the business are creating value and which are destroying it, providing a more robust measure than traditional accounting metrics.
  • 41 Capital Allocation and Investment Decisions: EVA guides decisions on allocating capital to new investments and projects. Projects with expected positive EVA are prioritized, as they are anticipated to generate returns above the Weighted Average Cost of Capital. This ensures that investments contribute positively to shareholder value.
  • 40 Incentive Compensation: Many companies link management and employee compensation to EVA performance. This aligns the interests of employees with those of shareholders, motivating them to make decisions that enhance economic value. Joel Stern, a co-founder of Stern Stewart & Co., highlighted this aspect, stating that highly successful implementations of EVA often involve extending it throughout the organization.
  • 39 Valuation: EVA can be used as a basis for company valuation. The sum of a company's invested capital and the present value of its future Economic Value Added can approximate its total value. Cas38e studies, such as the implementation of EVA by the United States Postal Service, demonstrated its ability to eliminate losses and improve performance by integrating it into performance measurement and incentive systems.

##37 Limitations and Criticisms

Despite its advantages, Economic Value Added (EVA) is not without limitations and has faced criticisms. One primary concern is the subjectivity involved in making the numerous accounting adjustments required to transform traditional financial statements into an economic basis. Wh35, 36ile Stern Stewart & Co. identified potentially over 160 adjustments, in practice, only a few key ones are typically made, which can still be complex and subjective.

C34ritics also point out that EVA, while aiming for a longer-term view than some traditional metrics, can still be perceived as focusing on short-term earnings, potentially incentivizing managers to prioritize immediate results over long-term strategic growth opportunities. Fo31, 32, 33r instance, investments in research and development or brand building, which are crucial for future growth, might initially reduce EVA if their benefits are not immediately recognized, potentially discouraging such investments.

Fu29, 30rthermore, the accurate estimation of the Weighted Average Cost of Capital is crucial for EVA calculation, and this can be challenging due to assumptions about risk, market conditions, and discount rates, which can introduce subjectivity. EV27, 28A is generally more suitable for asset-rich companies, and its utility may be limited for businesses with significant intangible assets, such as technology companies, where conventional capital investment might be low but intellectual capital is paramount. The24, 25, 26refore, EVA should be used in conjunction with other financial metrics and qualitative analysis for a comprehensive understanding of a company's performance.

##22, 23 Economic Value Added vs. Net Income

Economic Value Added (EVA) and Net Income are both measures of profitability, but they differ fundamentally in their approach and the insights they provide.

  • 20, 21 Net Income (Accounting Profit): This is the "bottom line" figure reported on a company's income statement. It represents the profit remaining after all operating expenses, interest, taxes, and depreciation have been deducted from revenue. Net income adheres to generally accepted accounting principles (GAAP) and primarily reflects historical financial transactions. It does not explicitly account for the cost of equity capital.

  • 18, 19 Economic Value Added (EVA): EVA, on the other hand, is a measure of economic profit. It takes Net Operating Profit After Taxes (NOPAT) and subtracts a charge for the use of all capital, including both debt and equity. The key distinction is that EVA explicitly recognizes that equity capital is not free; shareholders expect a return on their investment. If a company's operations don't generate enough profit to cover this implicit cost, even if it reports a positive net income, it might be destroying shareholder value.

In16, 17 essence, while net income tells you how much money a company has made based on accounting rules, EVA tells you how much wealth the company has truly created for its shareholders after accounting for the full cost of its capital.

##14, 15 FAQs

What is the primary purpose of Economic Value Added (EVA)?

The primary purpose of Economic Value Added (EVA) is to measure a company's true economic profit and assess whether it is creating or destroying shareholder value. It does so by explicitly factoring in the cost of all capital used by the business.

##11, 12, 13# How does EVA account for the cost of capital?
EVA accounts for the cost of capital by deducting a "capital charge" from the Net Operating Profit After Taxes (NOPAT). This capital charge is calculated by multiplying the total invested capital by the Weighted Average Cost of Capital, representing the minimum return required by both debt and equity providers.

##8, 9, 10# Can a company have a positive net income but a negative EVA?
Yes, a company can have a positive net income but a negative Economic Value Added. This occurs when the accounting profit is positive, but it is not sufficient to cover the full opportunity cost of the capital invested by shareholders. In such a scenario, the company is not generating enough return to meet investor expectations, effectively destroying value despite appearing profitable by traditional accounting standards.

##6, 7# Is EVA used by all companies?
While EVA gained significant popularity, particularly among large, asset-heavy corporations in the 1990s, it is not universally adopted. Its applicability can be less straightforward for companies with significant intangible assets or those that are less focused on immediate shareholder profit. Many companies continue to use a combination of performance metrics.

##4, 5# What are common adjustments made to financial statements for EVA calculation?
Common adjustments to financial statements for EVA calculation aim to convert accounting figures to a more economic basis. These can include capitalizing and amortizing expenses like research and development (R&D) or advertising, which are typically expensed immediately in traditional accounting but provide long-term benefits. Other adjustments might involve converting operating leases to capital leases or modifying depreciation methods to reflect actual economic decline.1, 2, 3